Chapter 10

The Basics of Capital

Budgeting:
Evaluating Cash Flows
Topics
Overview and vocabulary
Methods
NPV
IRR, MIRR
Profitability Index
Payback, discounted payback
Unequal lives
Economic life
Optimal Capital Budget
2
 What is capital budgeting?
Analysis of potential additions to fixed assets
(projects).
Long-term decisions; involve large expenditures.
Very important to firms future firms growth,
and even its ability to remain competitive and to
survive. Typical examples include
Replacement of serviceable but obsolete asset to
reduce cost,
Expansion of existing products/markets or expansion
into new products/markets.
3
 Steps in Capital Budgeting
Estimate relevant cash flows (inflows &
outflows).
Assess risk of cash flows and determine
appropriate cost of capital (WACC for the
project)
Screening projects - evaluating cash flows
to find out net gain/loss to the firm.

4
Major Methods of Screening
Projects
NPV Net Present Value
IRR Internal Rate of Return
MIRR Modified Internal of Rate of
Return
Profitability Index
Payback/Discounted Payback Period

5
 Independent versus Mutually
Exclusive Projects
Independent projects projects are independent
when acceptance of one does not preclude the
acceptance of others. Each serves a different
purpose. Example: opening 2 stores in 2 different
areas.
Mutually exclusive projects projects are mutually
exclusive when acceptance of one precludes the
acceptance of others. All serve the same purpose.
Example: opening 2 stores in the same area, forklift
(truck) vs. conveyor belt to carry materials.

6
 Cash Flows for Franchise L
and Franchise S

0 1 2 3
Ls CFs: 10%

-100.00 10 60 80

0 1 2 3
Ss CFs: 10%

-100.00 70 50 20

7
 Net Present Value
Sum of the PVs of all cash inflows and
outflows of a project.
N
CFt
NPV (1 r )t
t 0

CF0 CF1 CF2 CFN

........
( 1 r )0 ( 1 r )1 ( 1 r )2 ( 1 r )N
CF1 CF2 CFN
CF0 ........
(1 r) 1
(1 r) 2
( 1 r )N
N
CFt
t
CF0 [as CF0 is typically an initial investment]
t 1 (1 r)
8
 Whats Franchise Ls NPV?
0 1 2 3
10%
Ls CFs:

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98
9
Decision Rule for the NPV Method

NPV = PV of inflows Cost(PV of outflows)

= Net gain in wealth
If projects are independent, accept if the
project NPV > 0.
If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
In this example, accept S if mutually exclusive
(NPVS > NPVL), and accept both if independent.
10
 Internal Rate of Return: IRR
0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0. That is,
N
CFt
0 t
t 0 (1 IRR)
11
 Whats Franchise Ls IRR?
0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV For our example projects L and S:
IRRL = 18.13%. IRRS = 23.56%

12
 Trial and Error Procedure of
estimating IRR
Consider the following example project -

13
IRR try different rates
An access to the present value annuity (PVA) table simplifies the job of
guessing!
In PVA tables we have 3 items rate, period and the PVA factor that lies at
the intersection of a particular combination of rate and period. The first
step to guessing would be to estimate an approximate PVA factor by
dividing the project cost by the average cash inflows over the life of the
project. And then use this approximate factor and the projects life (period)
to find a corresponding rate to try first. Note that normally we use PVA
table to find the PVA factor, given rate and period; and here we seem to
be given the factor and the period and trying to find out the rate.

NPV @ 20% = $44.46 [Rate is too low!]

NPV @ 25% = - $19.12 [Rate is too high!]

14
IRR solution - interpolation
0.20 $44.46
X $44.46
.05 IRR $0.00 $63.58
0.25 -$19.12

X $44.46
= X = 0.035
.05 $63.58
IRR = 0.20 + 0.035 = 0.235 or 23.50%
[My Excel Solution to IRR is 23%]

15
 Decision Rule for the IRR
Method
If IRR > WACC, the projects return exceeds its
costs and there is some return left over to boost
investor returns.
If IRR > WACC, accept project.
If IRR < WACC, reject project.
If projects are independent, accept both
projects, as both IRR > WACC = 10%.
If they are mutually exclusive, accept the one
with highest IRR, such that IRR > WACC .
16
Decisions on Projects S and L
per IRR
If S and L are independent, accept
both: IRRS > r (WACC) and IRRL > r
(WACC).

If S and L are mutually exclusive,

accept S because IRRS > IRRL .

17
 NPV Profiles
A graphical representation of project NPVs at different
costs of capital. Following our example projects, well
have the following estimates of NPVL and NPVS at
different discount rates:

WACC NPVL NPVS

0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
18
NPV Profiles
50 L
40 Crossover
Point = 8.7%
30
NPV ($)

20 S

10 IRRS = 23.6%

0
0 5 10 15 20 23.6
-10 Discount rate r (%) IRRL = 18.1%

19
 NPV and IRR: No conflict for
independent projects.

NPV ($)

IRR > r r > IRR

and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR
20
Mutually Exclusive Projects
NPV r < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT
L
r > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

8.7 %
IRRL 21
 NPV profiles - Summary conclusions
If projects are independent, the two
methods always lead to the same
accept/reject decisions.
If projects are mutually exclusive
If WACC > crossover rate, the methods lead
to the same decision and there is no conflict.
If WACC < crossover rate, the methods lead
to different accept/reject decisions.

22
 To Find the Crossover Rate
Find cash flow differences between the projects.
The estimated IRR of the cash flow differentials
is the crossover rate (in our case, its 8.68%,
rounded to 8.7%).
Can subtract S from L or vice versa, but easier
to have first CF negative.
If profiles dont cross, one project dominates the
other.

23
 Two Reasons NPV Profiles
Cross
Size (scale) differences the smaller project
effectively frees up some funds at t = 0 for
investment (i.e., lower initial investment). The
higher the opportunity cost, the more valuable
these funds are, so a high WACC favors small
projects.
Timing differences the project with faster
payback provides more CF in early years for
reinvestment. At a high WACC, early CFs are
especially good, NPVS > NPVL.
24
 Reinvestment Rate Assumptions
The root cause of NPV-IRR conflict
NPV method implicitly assumes that project CFs
are reinvested at WACC while the IRR method
assumes that CFs are reinvested at the IRR.
NPVs assumption is theoretically more correct
since net CFs from a project can be
(1) paid to debt and equity investors who on average
require a return equal to the cost of capital, i.e., this is
the minimum rate required by the investors,
or (2) used as a source of capital that would otherwise
be raised at the firms cost of capital.
25
 Reinvestment Rate Assumptions
(contd.)
Note that when we calculate a present value,
we are implicitly assuming that cash flows can
be reinvested at a specified interest rate!

26
Modified Internal Rate of
Return (MIRR)
MIRR is the discount rate that causes
the PV of a projects terminal value (TV)
to equal the PV of costs. TV is found by
compounding inflows at WACC.
Thus, MIRR assumes (explicitly) cash
inflows are reinvested at WACC.

27
Calculating MIRR
0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% 12.1
MIRR = 16.5%
-100.0 158.1
PV outflows TV inflows
$158.1
$100 =
(1 + MIRRL)3
MIRRL = 16.5%
28
To find TV with 10B: Step 1,
find PV of Inflows
First, enter cash inflows in CFLO register:
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

Second, enter I = 10.

Third, find PV of inflows:

Press NPV = 118.78

29
Step 2, find TV of inflows.
Enter PV = -118.78, N = 3, I = 10, PMT
= 0.

Press FV = 158.10 = FV of inflows.

30
Why use MIRR versus IRR?
MIRR correctly assumes reinvestment at
opportunity cost = WACC. MIRR also
avoids the problem of multiple IRRs.
Managers like rate of return
comparisons, and MIRR is better for this
than IRR.

31
Normal vs. Nonnormal Cash
Flows
Normal Cash Flow Project:
Cost (negative CF) followed by a series of positive
cash inflows.
One change of signs.
Nonnormal Cash Flow Project:
Two or more changes of signs.
Most common: Cost (negative CF), then string of
positive CFs, then cost to close project.
For example, nuclear power plant or strip mine.

32
Inflow (+) or Outflow (-) in
Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN

33
 Pavilion Project: NPV and IRR?
0 1 2
r = 10%

-800 5,000 -5,000

NPV = -386.78
IRR = ???

34
Nonnormal CFs--two sign
changes, two IRRs.

NPV NPV Profile

IRR2 = 400%
450
0 r
100 400
IRR1 = 25%
-800
35
Logic of Multiple IRRs
At very low discount rates, the PV of
CF2 is large & negative, so NPV < 0.
At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
Result: 2 IRRs.

36
Profitability Index
The profitability index (PI) is the
present value of future cash flows
divided by the initial cost.
It measures the bang for the buck.

37
 Franchise Ls PV of Future
Cash Flows

Project L:
0 1 2 3
10%

10 60 80

9.09
49.59
60.11
118.79 38
Franchise Ls Profitability
Index

PV future CF $118.79
PIL = =
Initial Cost $100

PIL = 1.1879

PIS = 1.1998

39
What is the payback period?
The number of years required to
recover a projects cost,

or how long does it take to get the

businesss money back?

40
 Payback for Franchise L

0 1 2 2.4 3

CFt -100 10 60 80
Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

41
 Payback for Franchise S

0 1 1.6 2 3

CFt -100 70 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

42
Strengths and Weaknesses of
Payback
Strengths:
Provides an indication of a projects risk
and liquidity.
Easy to calculate and understand.
Weaknesses:
Ignores the TVM.
Ignores CFs occurring after the payback
period.
43
 Discounted Payback: Uses
discounted rather than raw CFs.

0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.44

 Evaluating Projects (mutually
exclusive) with Unequal Lives:
Replacement Chain or Common Life Approach:
Analyzing alternatives over an equal life.
Equivalent Annual Annuities Approach:
Finding the constant payment streams (annuity) that
the projects NPVs would provide over their respective
lives.
Some caveats:
Note that the question of unequal lives does not arise with respect
to independent projects. If you dont encounter a significant
differences in project lives, extending the analysis to a common life
may not be appropriate as the project may not actually be repeated
or, even if repeated, CFs may change!
45
 S and L are mutually exclusive
and will be repeated. r = 10%.

0 1 2 3 4

Project S:
(100) 60 60
Project L:
(100) 33.5 33.5 33.5 33.5
Note: CFs shown in $ Thousands

46
NPVL > NPVS. But is L better?
S L
CF0 -100 -100

CF 60/year 33.5/year

NJ 2 4
I 10 10

NPV 4.132 6.190

47
Put Projects on Common Basis
Note that Project S could be repeated
after 2 years to generate additional
profits.
Use replacement chain to put on
common life.

48
 Replacement Chain Approach (000s).
Franchise S with Replication:

0 1 2 3 4

Franchise S:
(100) 60 60
(100) 60 60
(100) 60 (40) 60 60

NPV = $7,547.
49
 Or, use NPVs:

0 1 2 3 4

4,132 4,132
3,415 10%
7,547

Compare to Franchise L NPV =

$6,190.
50
 Suppose cost to repeat S in two
years rises to $105,000.

0 1 2 3 4

Franchise S:
(100) 60 60
(105) 60 60
(45)
NPVS = $3,415 < NPVL = $6,190.
Now choose L. 51
Equivalent Annual Annuity
Approach (EAA)
Convert the NPV into a stream of
annuity payments over the projects life.
S: NPV=4.132, N=2, WACC=10
Solve for PMT = EAAS = $2.38.
L: NPV= 6.190, N=4, WACC=10
Solve for PMT = EAAL = $1.95.
S has higher EAA, so it is a better
project.
52
 Economic Life versus Physical
Life
Should you always operate for the full
physical/engineering life (serviceable life)?
Physical life may be longer than an assets
economic life the life that maximizes the NPV
and thus shareholder wealth.
Consider another project with a 3-year life. See
next slide for cash flows.
If terminated prior to Year 3, the machinery will
have positive salvage value and the firms will
probably save some cost of maintenance.

53
Economic Life versus Physical
Life (Continued)
Year CF Salvage Value

0 ($5000) $5000

1 2,100 3,100

2 2,000 2,000

3 1,750 0

54
CFs Under Each Alternative
(000s)
0 1 2 3

1. No termination (5) 2.1 2 1.75

2. Terminate 2 years (5) 2.1 4

3. Terminate 1 year (5) 5.2

55
NPVs under Alternative Lives (Cost of
capital = 10%)
NPV(3) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
The project is acceptable only if
operated for 2 years.
A projects engineering life does not
always equal its economic life.

56
Optimal Capital Budget
Finance theory says to accept all
independent (and chosen mutually
exclusive) projects with positive NPV.
Two problems can occur when there is
not enough internally generated cash to
fund all positive NPV projects:
An increasing marginal cost of capital.
Capital rationing
57
 Increasing Marginal Cost of
Capital
Externally raised capital can have large
flotation costs, which increase the cost of
capital. If external funds will be raised, then
the NPV of all projects should be estimated
using this higher marginal cost of capital.
Investors often perceive large capital budgets
as being risky, which drives up the cost of
capital.

58
Capital Rationing
Capital rationing occurs when a
company chooses not to fund all
positive NPV projects.
The company typically sets an upper
limit on the total amount of capital
expenditures that it will make in the
upcoming year.

(More...) 59
 Capital Rationing: Some
explanations and solutions
Reluctance to issue new stock:
Companies want to avoid the direct costs (i.e.,
flotation costs) and the indirect costs (perceived
increased riskiness) of issuing new capital.
Solution:
Increase the cost of capital by enough to reflect
all of these costs, and then accept all projects
that still have a positive NPV with the higher cost
of capital.

(More...) 60
 Capital Rationing: Some
explanations and solutions
Constraints on non-monetary resources:
Companies dont have enough managerial,
marketing, or engineering staff to implement all
positive NPV projects.
Solution:
Use linear programming to maximize NPV subject
to not exceeding the constraints on staffing.

(More...) 61
 Capital Rationing: Some
explanations and solutions
Controlling estimation bias:
Companies believe that the projects managers
forecast unreasonably high cash flow estimates,
so companies filter out the worst projects by
limiting the total amount of projects that can be
accepted.
Solution:
Implement a post-audit process and tie the
managers compensation to the subsequent
performance of the project.
62